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Tuesday, September 16, 2014

Everyone HATES this ultra-cheap market

Actions and Consequences

October is coming. Excess liquidity is disappearing. And with the S&P 500 on a trailing P/E of 19.7, the index is fast approaching “sell territory.” Watch out.

We finished our series on investment theory last week. Now we turn to practical application. There are three parts to the investment world. The first part is Aristotelian, Cartesian, Pythagorean. It is a world of logic and calculations. He who calculates best wins.

The second part is Socratic and Emersonian. The investment world, like the rest of the world, follows moral rules. When you do something “wrong” you will pay the consequences.

Aristotle, hewn in stone

For example, when you forget to pay a parking fine… you will probably regret it. Leave a rake lying in the yard, turned up the wrong way, and you will almost surely step on it. Buy an expensive “story stock,” recommended to you by a broker you’ve never met, calling from Boca Raton, and you will most likely lose money.

That is true in a larger sense, too. An economy that goes too deeply into debt will have to bear the consequences. No amount of QE or negative real interest rates will make those consequences disappear. They can only distort and displace them.

This is not to say that moral rules will play out the way you expect in every instance. It is wrong to kill. But had you snuffed a certain house painter in Vienna at the turn of the last century, the world might not necessarily be a worse place.

Likewise, not every foolish bet goes bad. Still, you’re probably better off believing it will. The third part of the investment world is completely unpredictable and unfathomable. Mr. Market gets up to mischief from time to time; he drives moralists mad and logicians to drink.

US Stocks Are Expensive

The numbers we presented yesterday show that the average investor does not beat the indexes… not even close. According to data from Dalbar, he consistently lags just about every asset class there is.

This leads the Efficient Market Hypothesis crowd to say: Just buy an index fund. You can’t beat the market. But our Simplified Trading System (STS) tells us there’s a good time to buy and a bad time.

“Buy low and sell high,” is the basic rule. US stocks are now expensive. The trailing P/E for the S&P 500 is 19.7. The 10-year cyclically adjusted P/E ratio (Shiller P/E of CAPE) for the index is even higher – at 26.3.

What do you do when when US stock valuations are so high? Well, you need to find markets that aren’t so pricey.

US stock market: real price vs. real Shiller P/E as of August (via Doug Short). Prices are 85% above their long term regression, P/E 10 is 35% above. Cheap this is not (and no, 1929 and 2000 are not yardsticks of what constitutes an expensive market, they are examples of complete mass insanity). The current P/E 10 is almost at the 93rd percentile of all data since 1871 – click to enlarge.

Russian Stocks Are On Sale

Such as the Russian stock market! There, the trailing P/E is under 6.

You’re thinking: “Hmm… Russian stocks are treacherous. Everybody says so. And with the war in Ukraine and the sanctions regime, they could go much lower.”

One of our own clever readers, Bradley P., warns:

The downside on Russian stocks is still 100% from here. Mathematically that is the maximum loss one can have buying Russian stocks.

Once in the last hundred years that happened; when the Bolsheviks closed the stock market in 1917. [...]

Since US stock markets have never lost 100%, while Russian ones have, by a historical perspective US stocks, even at 20 times earnings, are likely a better investment than Russian stocks (never mind whether they use an accounting system you can trust).

Just wait until Russia closes the market to foreign investors, issues capital controls and the ADRs and ETFs go to zero.”

Bradley may be right. But we don’t presume to know – neither what is really going on now… nor what it will mean for the future. Neither in Russia nor in the US. All we know is that our calculations (as primitive as they are) tell us you get more value per dollar in Russia.

And our “moral” rule tells us that you don’t make money speculating on the future. You make money by buying wisely in the present.

Our guess is that Mr. Market aims to make fools of as many investors as possible. And right now, there are far more investors who are short or out of Russian equities than there are those who are long.

Still ahead: how to pick stocks to beat the market… how to get rich… and why it might be better to stay poor.

Russia’s RTS Index. The market-wide P/E is at about 5, many stocks pay dividends ranging from 6.5% up to 10%. Naturally, the news are bad. The news are always bad when a market is cheap. When US equities were last trading at single digit trailing P/Es in the late 1970s, the “death of equities” was proclaimed by the press. That’s just the way it goes…when stocks are expensive, the crowd is clamoring for them. When they are cheap, nobody wants them – via Investing.com.